MASTERARBEIT. Titel der Masterarbeit

Transcription

1 MASTERARBEIT Titel der Masterarbeit The Reputational Effect of Venture Capitalists on the post-ipo long-term Operating Performance of Portfolio Companies - An empirical analysis of U.S. VC-backed IPOs between 2003 and 2006 verfasst von Daniel Stapelfeldt angestrebter akademischer Grad Master of Science (MSc) Wien, 2013 Studienkennzahl lt. Studienblatt: A Studienrichtung lt. Studienblatt: Masterstudium Betriebswirtschaft Betreuer / Betreuerin: Univ.-Prof. Dr. Gyöngyi Lóránth

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3 ACKNOLEDGEMENTS The writing of this master thesis has been a very challenging experience. The completion would not have been possible without the contribution of several persons. Therefore, I would like to acknowledge the following people for their support, encouragement and advice with this master thesis. First of all, I would like to express my deepest gratitude to my supervisor, Prof. Dr. Gyöngyi Lóránth for supervising this thesis and supporting me throughout the whole writing process. The topic emerged in the course of an interesting seminar in Corporate Finance held by Prof. Lóránth at the University of Vienna in This master thesis would have been impossible without getting access to Dow Jones Venture Economics Database which was provided by Mag. Michal Nespor. For this reason, I want to express my heartfelt thank to him for giving me the opportunity to extract data from this database and for his time and effort to answer my s and attend our meeting. I also owe very special thanks to Dr. Maria Chiara Iannino from the University of Vienna who donated her spare time to deliberate with me on my empirical analysis and provided great advice in handling EViews and empirically verifying my hypotheses. And last but not least, I would like to thank my family for providing the greatest support in every imaginable respect throughout my whole master program with their greatest dedication and thus contributed with their invaluable encouragement to the successful completion of this thesis and the whole master program. Daniel Stapelfeldt Vienna, September 2013

4 The Reputational Effect of Venture Capitalists on the post- IPO long- term Operating Performance of Portfolio Companies An empirical analysis of U.S. VC- backed IPOs between 2003 and 2006 Daniel Stapelfeldt University of Vienna September, 2013 Abstract This master thesis examines the reputational effects of lead Venture Capital firms on the post- IPO long- term operating performance of their portfolio companies. The thesis is based on the Grandstanding Hypothesis by Gompers (1996) to draw inferences on performance differences between portfolio companies backed by reputable and less reputable Venture Capital firms. Operating performance is measured upon eight different performance measures over a time horizon of up to three years after the IPO. To distinguish between reputable and less reputable VC firms, a hand- collected sample of 143 IPOs between 2003 and 2006 is decomposed in two subsets at the average age of the lead VC firms at their portfolio companies IPO. The empirical analysis finds no significant and overall outperformance of portfolio companies backed by reputable VC firms, instead portfolio companies backed by less reputable VC firms exhibit almost similar performances on the investigated performance measures. These results contradict existing empirical investigations on a similar research topic. Keywords: Venture Capital; Initial Public Offering; Reputation

5 TABLE OF CONTENTS LIST OF FIGURES LIST OF TABLES LIST OF ABBREVIATIONS I III IV V CHAPTER 1: INTRODUCTION 1.1 Motivation and Problem Statement Outline 2 CHAPTER 2: THE VENTURE CAPITAL INVESTMENT PROCESS 2.1 The Importance of the Venture Capital industry Venture Capital Fund Structure Screening and Due Diligence of VC Investments The Syndication of VC Investments Staging in Venture Capital investments Contractual Agreements between Entrepreneurs and VC firms Monitoring and Value Adding Services The Initial Public Offering as an Exit Strategy Fund returns and Performance Persistence 25 CHAPTER 3: REPUTATIONAL EFFECTS AND THE GRANDSTANDING HYPOTHESIS 3.1 Reputation in the Venture Capital Industry The Importance and Benefits of Reputation Indicators to Measure Reputation Reputational Effects on Screening, Monitoring and operational Performance The Grandstanding Hypothesis 38 CHAPTER 4: METHODOLOGY, DATA SET AND PERFORMANCE MEASURES 4.1 The Data Set Determination of the Lead Investor Sample Division Performance Metrics and Research Hypotheses Underpricing at the IPO date Money left on the table Tobin s Q Industry- adjusted Return on Assets EBITDA/Sales and EBITDA/Assets Stock returns and Wealth Relatives 55

6 II CHAPTER 5: EMPIRICAL ANALYSIS 5.1 Univariate Analysis, Descriptive and Inferential Statistics Characteristics Portfolio Companies Characteristics of lead Venture Capital Firms Descriptive Statistics and Significance Tests of Performance Indicators Multivariate Analysis Methodology and Control Variable Selection Reputational Effect of VC Age on the post- IPO operating Performance Robustness Tests Reputation Indicator: Portfolio Companies publicly held Reputation Indicator: Reputation Index 91 CHAPTER 6: CONCLUDING REMARKS 6.1 Conclusions Suggestions for further Research 93 BIBLIOGRAPHY 95 APPENDICES 102

7 III LIST OF FIGURES FIGURE 1: U.S. VC- BACKED COMPANY EMPLOYMENT FROM FIGURE 2: REVENUES OF U.S. VC- BACKED COMPANIES FROM FIGURE 3: INVESTORS IN VENTURE CAPITAL FUNDS 8 FIGURE 4: THE ORGANIZATIONAL STRUCTURE OF A VENTURE CAPITAL DEAL 10 FIGURE 5: VENTURE CAPITAL- BACKED IPOS AS A FRACTION OF TOTAL U.S. IPOS FROM FIGURE 6: THE EXIT ROUTES OF VC- BACKED FIRMS BETWEEN 1991 AND

8 IV LIST OF TABLES TABLE 1: DESCRIPTIVE STATISTICS ON THE FULL SAMPLE OF VC- BACKED PORTFOLIO COMPANIES 60 TABLE 2: DESCRIPTIVE STATISTICS FOR PORTFOLIO COMPANIES BACKED BY LESS REPUTBLE VC FIRMS 62 TABLE 3: DESCRIPTIVE STATISTICS FOR PORTFOLIO COMPANIES BACKED BY REPUTABLE VC FIRMS 62 TABLE 4: SIGNIFICANCE TESTS ON MEANS FOR CHARACTERISTICS OF PORTFOLIO COMPANIES BACKED BY LESS REPUTABLE AND REPUTABLE VC FIRMS 63 TABLE 5: DESCRIPTIVE STATISTICS ON THE FULL SAMPLE OF VC FIRMS 64 TABLE 6: DESCRIPTIVE STATISTICS ON THE INDUSTRY FOCUS FOR THE FULL SAMPLE OF VC FIRMS 64 TABLE 7: SIGNIFICANCE TESTS FOR CHARACTERISTICS OF REPUTABLE AND LESS REPUTABLE VC FIRMS 65 TABLE 8: UNDERPRICING AND MONEY LEFT ON THE TABLE FOR THE FULL SAMPLE OF PORTFOLIO COMPANIES 66 TABLE 9: UNDERPRICING AND MONEY LEFT ON THE TABLE FOR THE FULL SAMPLE 67 TABLE 10: DESCRIPTIVE STATISTICS ON TOBIN'S Q FOR THE ADJUSTED SAMPLE 69 TABLE 11: INFERENTIAL STATISTICS ON TOBIN'S Q FOR PORTFOLIO COMPANIES BACKED BY REPUTABLE AND LESS REPUTABLE VC FIRMS 70 TABLE 12: INFERENTIAL STATISTICS ON THE INDUSTRY- ADJUSTED ROA FOR FIRMS BACKED BY LESS REPUTABLE AND REPUTABLE VC FIRMS 71 TABLE 13: THREE- YEAR AVERAGE EBITDA/ASSETS RATIO FOR PORTFOLIO COMPANIES BACKED BY LESS REPUTABLE AND REPUTABLE VC FIRMS 73 TABLE 14: THREE- YEAR AVERAGE EBITDA/SALES RATIO FOR PORTFOLIO COMPANIES BACKED BY LESS REPUTABLE AND REPUTABLE VC FIRMS 73 TABLE 15: INFERENTIAL STATISTICS ON BUY- AND- HOLD RETURNS FOR THE FULL SAMPLE 75 TABLE 16: WEALTH RELATIVES ON THE FULL SAMPLE OF PORTFOLIO COMPANIES BACKED BY LESS REPUTABLE AND REPUTABLE VC FIRMS 78 TABLE 17: REGRESSION RESULTS FOR VC AGE ON UNDERPRICING 82 TABLE 18: REGRESSION RESULTS FOR VC AGE ON MONEY LEFT ON THE TABLE 83 TABLE 19: REGRESSION RESULTS FOR VC AGE ON TOBIN'S Q 84 TABLE 20: REGRESSION RESULTS FOR VC AGE ON INDUSTRY- ADJUSTED ROA 86 TABLE 21: REGRESSION RESULTS FOR VC AGE ON EBITDA/ASSETS AND EBITDA/SALES 87 TABLE 22: REGRESSION RESULTS FOR VC AGE ON BUY- AND- HOLD RETURNS 88 TABLE 23: REGRESSION RESULTS FOR VC AGE ON WEALTH RELATIVES 89

9 V LIST OF ABBREVIATIONS adj. Adjusted AR Abnormal Return AT Assets Total BHR Buy- and- Hold Return CAR Cumulative Abnormal Return CEO Chief Executive Officer CF Cash Flow CRSP Center for Research Security Prices CSHO Common Shares Outstanding EBITDA Earnings Before Interest, Taxes, Depreciation, Amortization GDP Gross Domestic Product GP General Partners IP Initial Offering Price IPO Initial Public Offering IQR Inter Quartile Range IRR Internal Rate of Return LP Limited Partners M&A Mergers & Acquisitions MLOTT Money Left on the Table NI Net Income OLS Ordinary Least Squared PC Closing Bid Price at IPO PFC Portfolio Company PME Public Market Equivalent PRCC Closing Bid Price at the end of the year PSTK Book Value of Preferred Stock R&D Research and Development ROA Return on Assets S&P 500 Standard & Poor s 500 SEQ Stockholders Equity SIC Standard Industrial Classification STDEVIATION Standard Deviation

10 VI TQ TVPI TXDITC U.S. UK UP VC VCs VOL WR WRDS Tobin s Q Total Value To Paid In Capital Balance Sheet Deferred Taxes and Investment Tax Credit United States United Kingdom Underpricing Venture Capital Venture Capitalists Volume Wealth Relative Wharton Research Data Services

11 1 CHAPTER 1: INTRODUCTION 1.1 Motivation and Problem Statement The importance of Venture Capital (VC) as a source of funding for new enterprises has grown enormously in the U.S. since the 1980s. Especially in the time period between 1990 and 2000 Venture Capital- backed initial public offerings (IPOs) reached considerable amounts but dramatically decreased after the turn of the millennium. The sudden downturn was due to the crash of the dot.com bubble, thus IPOs backed by venture capitalists have become infrequent up to the present day in the U.S compared to the 1990s. As VC gained more importance, the variety of literature began to grow simultaneously, albeit most of existing literature is concentrated in the early years of the 21th century. One field of literature focuses on the significance of reputation in the VC industry and addresses the post- IPO performance differences of Venture Capital- backed and non- Venture Capital- backed firms. However, literature investigating the VC firms reputational effects on post- IPO performance of portfolio companies that are backed by reputable and less reputable Venture Capital firms is scarce. Since VC firms need to recapitalize themselves periodically for the setup of a follow- on fund, reputation and signaling play a central role in this industry. Gompers (1996) is one of the first who analyzed comprehensively the reputational effect of VC firms on their portfolio companies and called it The Grandstanding Hypothesis. This hypothesis predicts that especially young and less reputable VC firms rush their portfolio companies to an IPO in order to quickly enhance their reputation and standing in the industry, signal credibility and thereby benefitting from an alleviated access to investors capital for follow- on funds. On the downside, precipitous IPOs are costly for Venture Capitalists. As a result, portfolio companies are underpriced at the IPO date, have experienced less monitoring by the VC firm and their equity stakes in the portfolio companies are considerably smaller compared to those held by reputable VC firms. This raises the question whether portfolio companies also suffer from the above- mentioned consequences of a rapid IPO exit in terms of worse operating performance in the long- term. In other words, do portfolio companies backed by less reputable VC firms exhibit worse post- IPO operating performance than firms backed by reputable VC firms? Is the greater underpricing simply due to greater uncertainty around the IPO or do start-

12 2 ups backed by less reputable VC firms face considerable performance issues and cannot match their counterparts in the long- run? To draw overall inferences, this master thesis applies an empirical analysis based on the calculation of several empirically verified performance measures and conducts a regression framework to determine whether the VC firm s reputational effect and other factors positively impact a portfolio company s post- IPO operating performance. The general assumption of this thesis is that portfolio companies backed by the less experienced VC firms perform considerably worse than firms backed by reputable VC investors. To the best of the author s knowledge, this thesis is the only empirical investigation that applies eight different indicators including financial ratios and stock returns over a three- year time horizon to evaluate a portfolio company s post- IPO performance. 1.2 Outline This master thesis is divided into six chapters which can further be split into a theoretical and an empirical part. Chapters 2 and 3 provide the theoretical background, whereas chapters 4 and 5 largely deal with the empirical analysis. Generally, this thesis is structured as follows: Chapter 1 provides background information on the motivation for the selection of the topic and showcases the structure of this thesis. In chapter 2, a comprehensive overview of the Venture Capital life cycle and the entire investment process is presented. The chapter starts by stating the importance of Venture Capital for the U.S. economy and continues with the description of a common Venture Capital fund structure. In the following, the Venture Capital investment process is presented, beginning with the initial screening and due diligence of start- ups business plans and closing with empirical evidence on VC funds returns and performance persistence. Interim steps such as the syndication, staging and monitoring of investments as well as common contractual provisions and the IPO as the most effective exit strategy are further elucidated. Chapter 3 provides existing empirical evidence on the effect of reputation in the Venture Capital industry. The paper Grandstanding in the Venture Capital Industry by Gompers (1996) plays a central role and is discussed in greater detail since it serves as a basis for the thesis main considerations.

13 3 Chapter 4 showcases the applied methodology for the empirical part. Apart from justifying the sample s choice and the determination of the lead Venture Capital firm, the division of the sample to account for the VC firm s reputation as well as the indicators to measure the portfolio companies post- IPO operating performance are presented. In chapter 5, the results of the empirical investigation are provided. The chapter kicks off with descriptive and inferential statistics on the VC firms and their portfolio companies consequently linking it to existing empirical evidence. Subsequently, results of the regression analysis are provided and interpreted. To verify the results, a robustness test using two additional reputation proxies is conducted. This thesis closes with chapter 6 summarizing the main findings and alleging suggestions for future research on this topic.

14 4 CHAPTER 2: THE VENTURE CAPITAL INVESTMENT PROCESS To fully understand the complex rationale of Venture Capital funding, a closer look at the whole Venture Capital life cycle with all its different steps is inevitable. To put it simply, the life cycle starts with raising money for a VC fund with a predetermined life time, continues with using the proceeds to invest in promising portfolio companies which are constantly made more valuable through monitoring services and at a final stage transacted through various forms thus the VCs leave providing investors with high returns. The cycle renews itself with VCs raising additional money for a follow- on fund (Gompers and Lerner (2001)). It is hard to distinguish exactly between each of the different steps because they often overlap and are linked with previous or subsequent steps. In this chapter, the thesis at hand aims to provide a comprehensive overview about the most important interim stages within the Venture Capital life cycle. At first, the importance of the Venture Capital industry is elucidated on the basis of industry data. Subsequently, the VC life cycle is presented starting with a general description of a VC fund s organizational fund structure as well as important interim steps such as screening, syndication, staging, monitoring and established contractual provisions. Finally, the IPO as one potential but most promising exit strategy is presented also referring to the performance and returns of VC funds. All steps are discussed with reference to a large variety of existing empirical investigations. 2.1 The Importance of the Venture Capital industry The Venture Capital industry has evolved as an important branch of the U.S. economy in the last decades. First recordings on Venture Capital deals date back to the early 20 th century, however it predominantly gained importance and contributed to a large extent to the competitive strength of the U.S. economy since the 1990s. Several empirical studies have investigated the importance and impact of VC financing on the economy (see e.g. Kortum and Lerner (1998); Hellmann and Puri (2000); Gompers and Lerner (2001) and The National Venture Capital Association (2009) and (2011)). According to a yearly report published by The National Venture Capital Association (2011), the presence of Venture Capital mainly affects the employment sector, industry- specific revenues and the creation of new industry segments. By financing young start-

15 5 ups, VCs not only help entrepreneurs to turn innovative ideas and scientific advances into new products and services but also drive U.S. job creation and foster the economic growth. Hellmann and Puri (2000) find supporting evidence and conclude from their empirical investigation that the presence of VC firms allows start- ups to bring their products faster to the market thus fostering their competitive position. In the period between venture- backed companies even outperformed the total U.S. economy in terms of employment and revenue growth. 1 As of 2010, almost 11.9 million venture- backed jobs were registered in the U.S. which is a total of 11% of the U.S. Private Sector Employment (total: million jobs). Figure 1 depicts that the share of VC- backed jobs steadily increased since the millennium as well as the total number of VC- backed jobs with one exception in Even in times of a recession (during the financial crisis of 2008) VC- backed firms experienced an employment decline as little as 2%, whereas the whole economy suffered from an employment downturn of 2.6%. FIGURE 1: U.S. VC- BACKED COMPANY EMPLOYMENT FROM Between employment decreased by 2.0% for VC- backed companies in comparison to a decline of 3.1% for the total U.S. private employment. In terms of revenue growth, VC- backed firms outperformed the U.S. economy by 3.1% (1.6% of revenue growth for VC- backed firms versus - 1.5% for the whole U.S.). 2 Data for figure 1 is retrieved from The National Venture Capital Association (2011).

16 6 The same impressive history becomes obvious when shifting the focus to revenues generated by VC- backed portfolio companies. In 2010, the companies in question have realized sales of almost $3.1 trillion equaling 10% of the total U.S. sales ($30 trillion) and 21% of the U.S. GDP. Presenting the history of U.S. VC- backed companies revenues, figure 2 shows a similar pattern as the one on employment. Since the year 2000, a steady ascending slope is displayed until 2010 with a simultaneous increase of revenues generated by VC- backed firms in relation to the U.S. GDP. FIGURE 2: REVENUES OF U.S. VC- BACKED COMPANIES FROM The VC industry also plays a crucial role in funding new industry branches. According to The National Venture Capital Association (2011) more than 4,800 companies have been funded in the health care branch and a number exceeding 17,000 firms in the field of information technologies. The industry sectors range from biotechnology to clean technologies including pollution control, alternative energy solutions, energy storage and ways to use energy more efficiently. More than 900 companies received VC funding with respect to clean technologies. The extension of clean technologies is an important recent endeavor of the U.S economy. In 2008, $4.1 billion were solely invested by VCs in this industry segment making it the fastest growing sector among all industries. These measures ensure the profound development of start- ups to promise the prospective 3 Data for figure 2 is retrieved from The National Venture Capital Association (2011).

17 7 continuance of green jobs, innovations in climate enhancing technologies and important sustainability issues in the U.S. (The National Venture Capital Association (2009)). In California, VC activity is highest among all states in the U.S. More than 2.8 million people work for VC- backed companies there, generating revenues of $800 million. Over time, VCs have invested approximately $456 billion 4 since the early 1970s and allowed popular and recently highly successful large- scale employers such as Google, Cisco, Amazon, Apple, Microsoft, Starbucks, FedEx, Intel and Facebook to realize their innovative business ideas, thus strengthening the U.S. economy by high job and revenue creation (The National Venture Capital Association (2009)). It is stated that one third of the companies going public in the U.S. have received VC financing and further empirical results suggest that the presence of Venture Capital has a substantial impact on innovation in the U.S. economy (Sahlman (1990) and Kortum and Lerner (1998)). 2.2 Venture Capital Fund Structure Venture Capital funds are usually structured as non- tradable partnerships that last for eight to ten years and in which investors are not entitled to change their capital allocation. The investors capital contribution is a one- time decision and takes place at the time the fund is raised. The funds are organized as self- liquidating partnerships so that its termination after its predefined lifetime imposes the fund managers to a healthy discipline. In other words, managers do not grant poorly performing start- ups additional capital infusions, thus great VC funding may be a sign of high quality portfolio companies (Nahata 2008).The predetermined end of a fund s life forces VCs to liquidate their investments and distribute the proceeds to the investors at a certain point of time. Hence, VCs have the need to recapitalize themselves periodically in form of follow- on funds to remain an active position in the industry. VC firms usually run several overlapping funds at the same time. Each new fund starts about three to six years after the previous fund was launched. A portfolio of two to three funds guarantees the VC firm 4 The year 2000 experienced with $99.2 billion by far the highest amount of VC Dollars invested since the 1970s which can be explained by the industry boom in the field of information technologies. Since 2001, VC investments per year fluctuate between $18.9 billion (2003) and $30.4 billion (2007). It becomes obvious that VC investments have smoothed over time.

18 8 a continuous operating without quitting its business to acquire new capital from investors (Gompers (1996)). Over 80% of Venture Capital funds are organized as limited partnerships, where the VC firm serves as the general partner (GP). As figure 3 shows, the limited partners (LP), i.e. the investors of the VC fund, consist largely of wealthy individuals, institutional investors as well as private and public pension funds. FIGURE 3: INVESTORS IN VENTURE CAPITAL FUNDS 5 During the VC fund s life cycle, the LPs are constantly informed about the current status of a certain project or the activity on new investments, however they do not possess an active role for participating in policy decisions or in day- to- day operations of the fund (Gompers (1995) in Gompers (1996)).The LPs provide the fund with the required amount of capital that is raised in the period before the fund is launched. After the closing of the fund, the GPs start investing in encouraging start- up companies and promise to return the proceeds back to the LPs after the fund terminates. In case of a capital exhaustion, the GPs usually attempt to obtain further capital commitments for follow- on funds (Kaplan and Schoar (2005)). When investigating the size of 577 VC funds, Kaplan and Schoar (2005) estimated an average fund size of $102.9 million, whereas the average size of e.g. buyout funds is more than four times larger. The GPs in the limited partnership are compensated on the one hand by an annual management fee and on the other hand by a share of the profit realized through successfully transacted portfolio companies, also known as carried interest. Sahlman 5 Data retrieved from The National Venture Capital Association (2007).

19 9 (1990) concludes that the management fee is widely contingent on the capital committed. Only a few funds use the estimated value of the portfolio as a benchmark to settle the management fee. Generally, increasing the base management fee by the rate of consumer price inflation on a yearly basis is a common approach of fund managers. Over 50% of the funds surveyed by Venture Economics database charge an annual fee of 2.5% of the committed capital though the fee typically varies between 2-3%. The carried interest however accounts for the largest fraction of the GPs compensation. Sahlman (1990) reports carried interest rates of 20% on the realized fund gains for almost 90% of the funds in question (see also Gompers and Lerner (1997)). The remaining funds charge interest rates ranging between 15-30%. Carried interest is skimmed from the gains that the fund realizes. GPs are often entitled to their profit share without restriction and before the LPs are paid off, however some funds follow a different approach. Usually GPs cannot liquidate their entire shares directly at the IPO since lock- up provisions of up to 180 days restrain them from an immediate exit. It is widely recognized that reputable VC firms with impressive track records report higher carried interest rates on fund gains than young and inexperienced VCs. Figure 4 graphically presents the organizational structure of a VC fund previously described. The fund managers invest a part of the fund s committed capital into start- up companies and receive common equity in exchange. Common equity is analogous to the rationale of a call option where the holder has a claim to the firm s cash flows after all other claimants, e.g. debt holders are paid off. Equity holders, i.e. the LPs, have an unlimited gain potential but cannot lose more than their initial investment (Cumming, Fleming, and Schwienbacher (2006)).

20 10 FIGURE 4: THE ORGANIZATIONAL STRUCTURE OF A VENTURE CAPITAL DEAL 6 Several factors drive the demand for VC funds. Gompers et al. (1998) mention macroeconomic factors like the expected return on alternative investments and the general health of the economy. In a prosperous growing economy, entrepreneurs have incentives to start new businesses thus driving the need for VC funding. In contrast to that, rising interest rates cause the reverse effect and lower the attractiveness of VC funds since investors might not receive an adequate compensation for their venturesome investment compared to a less risky investment. 2.3 Screening and Due Diligence of VC Investments Before VCs arrive at the decision to fund a start- up company with a promising business idea and the closing of the contract, they spend a significant amount of time and effort to screen, evaluate and analyze the potential investment (Kaplan and Strömberg (2001)). New enterprises often face difficulties to raise money from banks or other financial institutions because they exhibit great uncertainty about future earnings and the ability to meet their interest expanses. Venture Capitalists often appear as a last resort to provide the required capital hence start- up companies regularly court for VC funding. Every year a large VC firm receives up to 1,000 requests and business plans and screens hundreds of investments before committing itself to provide funding. Ultimately, a VC 6 Based on Da Rin, Hellmann, and Puri (2012)

21 11 firm invests in only a few companies (Sahlman (1990) and (Barry 1994)). When choosing an investment VC firms usually tend to concentrate on a marked- off set of industries where they consider the potential of growth prospects and value additivity for the portfolio company to be the greatest as a result of their monitoring services (Jain and Kini (1995)). In advance of an extensive due diligence on the portfolio companies business plan and their financial situation, VCs undertake some initial considerations on the spectrum of which investments to fund in general. 7 According to Kaplan and Strömberg (2000) who investigated 42 investments in portfolio companies, VC firms at first consider whether the investment opportunity matches their overall investment strategy. Further, VCs are mostly attracted to a start- up s product or technology, its business model, the firm s competitive position in its markets segment and a high probability of the product s or technology s customer adaption. It is noteworthy, that VCs already consider the likelihood of selling their equity stake in the future portfolio company at a favorable price in the market after the expiration date of the VC fund before the actual investment has taken place. 8 Start- ups that show a high demand of future monitoring and a steady involvement of the VCs managers in the day- to- day business are less likely to be funded. The screening and due diligence is determined by a closer investigation of the management team, the start- up s business concept, the amount of capital required to fund the operations, the existing contracts as well as the market size and the prevailing conditions (The National Venture Capital Association (2007), Kaplan and Strömberg (2001)). Although financial aspects do play a role in the VCs evaluation process, explicit earnings and sales forecasts are not frequently employed. In contrast, VCs put high emphasis on the analysis of a start- up s competitors, the market attractiveness and the customer adaption of the product (Kaplan and Strömberg (2000)). The start- up s management team is a crucial risk factor and the VCs uncertainty about its performance and future behavior is greatest among all other aspects. Kaplan and Strömberg (2001) conclude that management risk is present in more than 60% of the potential investments in question. VCs are concerned about the management s or founder s 7 Although the majority of VC investments is undertaken in the information technologies industry, some VCs tend to focus predominantly on start- up s affiliated with e.g. healthcare products or clean technologies. 8 Kaplan and Strömberg (2000) estimate that for 21% of the investments under investigation, a favorable exit opportunity plays a crucial role in selecting the future portfolio company.

22 12 incentives who might show a lack of focus and refuses to disclose important information on the firm s performance fostering asymmetric information. In some cases, the VCs also identify the need to complete the existing management team with some own, more experienced and better skilled executives to guarantee the focus on the start- up s continuous development and the reduction of information asymmetry. VC firms often transfer the associated risks with new start- up s into specific contractual provisions to protect themselves against any unforeseen difficulties (Kaplan and Strömberg (2004)). It is a common approach of VC firms to syndicate their investments with other VC investors. After the evaluation of an investment VCs usually set up an investment analysis or memorandum containing extensive descriptions of the investment opportunity. The final decision to invest, as well as any further post- investment considerations are usually based on this memorandum which serves as a guideline throughout the whole investment process. 9 The memorandum is also used to inform other syndicated VC investors about the potential investment (Kaplan and Strömberg (2000)). The syndication of investments also offers a variety of benefits for a VC firm. Using the memorandum set up by another VC firm increases the information content, enhances the selection process and may be decisive for the final commitment of capital (Casamatta and Haritchabalet (2007)). 10 In an ideal world, the initial screening and due diligence lead to a successful exit of the portfolio company via trade sale or merger being equipped with a carefully selected team of managers and executives, substantially negotiated contract provisions as well as endowed with a product that exhibits great growth potential and high acceptance by customers (Jain and Kini (1995)). It is believed that superior screening and selection abilities of VCs have an impact on the post investment performance of their portfolio companies. Since VC firms make huge efforts to undertake due diligences on their investments which provides them with valuable information, they are privileged to pick out only the most promising ventures. Hence, the opportunity to fund only high quality start- ups is assumed to be a reason for 9 Almost 80% of the VC partnerships considered by Kaplan and Strömberg (2000) set up an investment memorandum. 10 Further benefits and adverse impacts of syndication are described more in detail in section 2.4.

23 13 the outperformance of VC- backed firms compared to non VC- backed firms over time (Brown (2005)) The Syndication of VC Investments Syndication is a widely used approach throughout various industries. Especially banks tend to engage in co- operations with other financial institutions when granting loans for not being the sole lender. Ljungqvist, Marston, and Wilhelm (2007) conclude that co- management among banks is often practiced on the basis of previously established strong ties. Syndicated investments are also typical for the Venture Capital industry since VCs exhibit the tendency to involve several other VC firms in their investment decisions rather than investing alone (Lerner (1994)). These syndicates have similar structures as e.g. joint- ventures in which one party brings in other partners for various reasons (Brander, Amit, and Antweiler (2002)). VCs are often closely bound in a large network of lawyers, accountants, investment banks and other VC firms. Tian (2011) provides some definitions for VC syndication. Generally speaking, the syndication of a VC investment can be understood as a co- operation of at least two VC firms for the exchange of capital and equity stakes in a portfolio company. In the course of time, two more specific definitions have manifested. In case a group of two or more VCs invests in a start- up firm but funds are provided from only one VC investor in each round for all of the rounds, the portfolio company is nevertheless classified as an individual- backed company. In contrast to that, a less rigorous definition states that an investment in an entrepreneurial firm is considered as syndicated if simply two or more VC firms are involved in the whole financing process. 12 The latter definition is verified by Brander, Amit, and Antweiler (2002) who consistently consider the involvement of more than one VC firm in an investment as a syndication. Existing literature provides a large variety of motivations and benefits for the syndication of VC investments. Lerner (1994) mentions that VCs should engage in co- operations especially with well- established VC firms when there is a high likelihood of future reciprocity. Sah and Stiglitz (1986) attribute higher capabilities of gathering, 11 The reputational effect of the VCs experience and whether their superior screening or monitoring abilities determine the advantageous performance of VC- backed firm over non VC- backed firms is discussed in chapter This definition is also applied in the course of the empirical investigation in this thesis.

24 14 absorbing and processing information to a group of investors rather than individuals which results in the selection of better investments. In addition, different investors have different industry and location- specific expertise. Sharing this knowledge with other VCs fosters the expansion of a VC s spatial radius and offers new investment opportunities to diversify its portfolio (Sorenson and Stuart (1999)). Portfolio companies that are backed by several VCs also benefit by an increase in value which is added through an improved deal flow among the investors, the increased likelihood for a VC firm to get in contact with further strategic alliance partners and the chances to secure follow- on funding for the entrepreneurial firm (Ljungqvist, Hochberg, and Lu (2005)). Further value creation is realized from the syndicate s members heterogeneous skills, information and industry expertise thus a broad variety of inputs is achieved for the portfolio companies. Another important benefit of syndicated investments is its contribution to the VCs ability to diversify its investment portfolio (see Casamatta and Haritchabalet (2007)). Spreading the invested capital over several different start- up companies allows a VC firm to diversify its risk associated with the investments and to expand the portfolio radius. A VC firm is not only able to invest in a variety of firms but also to enter investments at different development stages (Tian a (2011)).The initial screening and evaluation of a potential investment by more than one VC firm is another tool to minimize the VCs risk since even after an extensive due diligence the start- up s prospects might still be unclear so that a further evaluation by other VCs can contribute to a more effective selection of projects or continuation decisions (Brander, Amit, and Antweiler (2002)). The joint evaluation is of particular importance as stated by Sorenson and Stuart (1999) to overcome information asymmetries since the entrepreneur typically knows more about the investment opportunity and may try to window dress the new venture. The diversification of its portfolio and the reduction of overall risks are also the main assumptions of the syndication of investments proposed in the risk- sharing hypothesis of Lerner (1994). Brander, Amit, and Antweiler (2002) assume that a lack of financial resources may encourage VCs to enter collaborations with other VCs. However, they conclude that factors such as improving the bargaining power with the founder are more likely to

25 15 drive syndication in contrast to Casamatta and Haritchabalet (2007) who consider large deals to be syndicated more likely. The results on the effect of syndication are ambiguous. Stand- alone investments realized average returns of 15-20% whereas syndicated investments exhibit mean returns ranging from 35% to 39% thus syndicated investments clearly outperform non syndicated ones (Brander, Amit, and Antweiler (2002)).This is in line with results by Ljungqvist, Hochberg, and Lu (2005) who infer that a VCs network positively impacts its fund performance due to high- quality collaborations. Casamatta and Haritchabalet (2007) arrive at a contrary conclusion. On the basis of their selection hypothesis they argue that rates of returns should be higher for stand- alone investments because a complementary evaluation of an investment by another VC is only needed for marginal investments. Investment opportunities that initially turn out to be good can be realized without a second opinion. It is worth mentioning that especially inexperienced VC firms favor the formation of syndicated investments because their evaluation of the project is not accurate enough to gain a comprehensive overview about the entire investment. Hence, they try to form syndicates with more experienced VCs whenever this is optimal to do so. Contrary to that, experienced VCs are more reluctant to form syndicates due to the danger of suffering from competition thus they will either forgo the investment or seek to form syndicates with equally experienced investors (Casamatta and Haritchabalet (2007)). 2.5 Staging in Venture Capital investments In contrast to entering in a stock- purchase agreement where the price and the timing are predetermined, VCs usually tend to invest at several different stages in their portfolio companies. For this reason, staging can be defined as a stepwise disbursement of VC firms to their portfolio companies. The amount of capital provided at each round is just sufficient to take the start- up company to the next higher development stage where a further infusion of capital is required to continue operations. As the VC- backed firm increases in size over time, the amount of capital provided at each stage presumably increases continuously (see Sahlman (1990) and Kaplan and Strömberg (2002)). It is unlikely for VC firms to provide all the capital that the start- up requires to accomplish its business plan upfront, thus the money is spread over several

26 16 development stages instead (Sahlman (1990)). Existing literature differentiates between two different approaches of step- wise financing: milestone financing and round financing. Inducing capital round after round, i.e. ex post staging, each new tranche undergoes separate negotiations at the time the start- ups demand new money for further process. Financing a start- up on the basis of milestones, also known as ex ante staging, requires an exact predetermination of contractual contingencies such as the amount of revenues, the number of patents filed, etc. under which the firm is entitled to receive new capital. Gompers and Lerner (1997) refer to several covenants that determine the approach how a VC firm finances its portfolio company. Since the amount of money that a VC firm can provide to one start- up in its portfolio is stipulated to narrow excessive spending on unprofitable firms, the selection between milestone and round financing demands a close scrutiny. Hence, the amount of capital that a portfolio firm requires over its life cycle may be the deciding factor for the form of financing. One of the main reasons for VCs to apply stage financing is to maintain its flexibility in making decisions. By committing capital step- wise, VCs remain control over the decision to shut down operations completely and to refuse further financing if the portfolio company performs inappropriate (see also Kaplan and Strömberg (2000)). This covenant is crucial because it is likely that founders continue investing in unprofitable projects as long as the VCs provide capital. 13 A VC firm withholding capital commitments also signals the critical status of the portfolio company in question to other capital providers. On the contrary, if the firm exhibits an outstanding performance, the VCs reserve themselves the right to invest more capital. Generally, staging is an accepted procedure by the founders since they benefit from retaining a significantly greater stake in the company as if receiving all the required capital in advance. Further, founders are usually optimistic of their own capabilities to meet the predetermined goals that trigger the additional provision of money (Sahlman (1990)). Moreover, Kaplan and Strömberg (2000) name two important risk factors that cause VCs to stage their investments: uncertainty about the market size and the management in place. Existing literature provides various benefits of staged investments. Supplying the start- up with capital step- by- step and making it contingent on several performance indicators 13 This view is also consistent with findings by Gompers (1995).

27 17 reduces the hold- up problem that VCs are exposed to. If a VC firm starts investing into a portfolio company, the founder can hold up the VC firm by the risk to leave his venture for various reasons. The staging approach allows the VC firm to reduce the hold up problem because the amount of capital provided is just sufficient until the next development stage. Hence, the gradual build- up of human capital incentives the founder not to leave the start- up (Neher (1999) in Tian a (2011)). In the course of time, VCs are able to learn more about the firm they invest in because the achievement of certain contracted goals discloses information about the start- up. Therefore, VCs can use stage financing as a substitute for intensive monitoring of the portfolio company. 14 Tian a (2011) suggests that the higher the monitoring costs, the larger the number of financing rounds and the shorter the time gap between each round. In contrast to the benefits of staging stated above, Wang and Zhou (2004) also address certain disadvantages for the VC firm. First and foremost, staging is costly and demands a lot of effort and time because prior to each new capital infusion, the VC firm has to negotiate and write the contracts. In addition to that, staging incentivizes the entrepreneur to window- dress, i.e. to artificially boost earnings and enhance the start- up s performance to meet the specified goal at the last moment, thereby unlocking the next capital infusion by the VC firm. Empirical results by Tian a (2011) suggest that staging has a positive impact on a portfolio companies operating performance in the year of going public. The results are obtained by making the performance of the portfolio companies contingent on the distance of the entrepreneurial firm to the VC firm, i.e. the further the distance, the greater the monitoring costs. Therefore, a smaller number of financing rounds will impact the firms performance in a positive way when the costs to monitor the start- up is less. A greater distance between the VC firm and the portfolio company results in larger number of rounds, a smaller capital infusion per round and a shorter time gap between the stages. 2.6 Contractual Agreements between Entrepreneurs and VC firms Venture Capital deals are commonly structured as limited partnerships which invest in promising start- up firms. Hence, the VC firm enters in contracts with both outside 14 A detailed description of monitoring services is available in section 2.7.

28 18 investors providing the required capital and the entrepreneurial firm the VCs invest in. According to Sahlman (1990) contracts between VC firms and the entrepreneurs contain three important characteristics, notably: (1) providing and staging the committed capital and preserving the right to abandon the investment, (2) compensation systems that are contingent on the creation of value and (3) preserving means to force the management to distribute investment proceeds. These tailor- made and complex contracts spell out the rights and obligations to each group to fit the specific needs of various situations (see Sahlman (1990) and Bengtsson (2009)). A key feature in the detailed elaboration of the contracts is the VCs right to allocate separately cash flow rights (hereinafter CF rights), voting rights, board rights, liquidation rights and other control rights. The rights are allocated in a way that if the performance of the portfolio company is weak, the VCs obtain full control. On the contrary, when the performance improves, the entrepreneur is allocated more control rights. These rights are generally made contingent on observable indicators of financial and non- financial performance (Kaplan and Strömberg (2001)). In case of an increasing uncertainty of either the start- up or the founder, VCs may increase the pay performance sensitivity by making the entrepreneur s cash flow compensation increasingly convex in performance. This is chiefly achieved through compensation being more explicitly contingent on performance, more time vesting as well as fewer liquidation CF rights (Kaplan and Strömberg (2002)). One of the most important rights in these contracts are CF rights which are not trivial to measure since they are either dependent on the firm s performance or on remaining with the firm. CF rights can be defined as the fraction of the portfolio company s equity value that different investors, i.e. the VCs in the syndicated investment and the management have a claim to. With reference to a study conducted by Kaplan and Strömberg (2002) VCs control almost 50% of the CF rights, whereas founders are only entitled to 30% and others to 20%, respectively which indicates that entrepreneurs give up a large fraction of their ownership when entering into VC contracts. Further, board and voting rights are crucial features to control the portfolio company and to enhance decision- making. General tasks of the board managers are the hiring and evaluation of top executives as well as taking part in the advisory and resolution of firm- wide decisions and strategies. Actions such as the sale of assets, subsequent financings

29 19 or the decision on acquisitions are by contrast often subject to the voting rights of the firm s shareholders. Results by Kaplan and Strömberg (2002) reveal that VCs possess in 25% of the companies in question the majority of the board seats, whereas the founders do so in only 14% of the cases. When shifting the focus to voting rights which are commonly state- contingent, the VCs hold the majority in 41% of the sample investments of first VC rounds. VCs typically include further rights, e.g. optional redemption rights, exit rights and rights to mitigate agency problems. Exit and redemption rights entitle the VC firm to sell back shares, to sell shares in an acquisition or to force other shareholders to sell shares on acquisition (Bengtsson (2009)). As already described in section 2.4, management risk imposes the VC firm with great uncertainty. To overcome this uncertainty, contractual provisions such as a higher fraction of committed capital being withheld in case certain goals are not met or simply providing the VCs with a higher degree of control are integrated in the contracts. The same techniques are employed to mitigate the hold- up problem, i.e. the entrepreneur can hold- up the VCs by imposing it with the threat to leave the venture. By including non- compete and vesting provisions, the VCs ensure that an ultimate departure of the founder becomes very expensive (Kaplan and Strömberg (2001)). As mentioned in the beginning of this section, rights can be contingent on financial and non- financial performance, e.g. actions, dividend payments, continued employment, future security offerings, etc. Kaplan and Strömberg (2002) find 17% of the investments being contingent on financial performance, 9% on non- financial performance and 11% on actions, respectively. Furthermore, additional funding may also be contingent on subsequent performance. Contingencies can also be made, e.g. on the EBIT or on the firm s net worth. If these two indicators fall below a predetermined threshold the VC firm obtains additional voting control power from the entrepreneur. The results clearly depict that contractual provisions between a VC firm and an entrepreneur can be very restrictive. Jain and Kini (1995) assume that only entrepreneurs who are confident in meeting the contracted goals and anticipate significant benefits from an affiliation to VC funding will embark on these provisions. Coincidently, solely VC firms that exhibit a track record of success and are associated with a great reputation can achieve entrepreneurs to agree to their restrictive conditions. However, entrepreneurs are potentially given the possibility to relax certain

30 20 provisions in renegotiations. In about one third of investments considered by Kaplan and Strömberg (2002) contractual rights from a previous financing round are negotiated and get part of the new contract. The two most commonly renegotiated provisions are the automatic conversion price which is typically increased as well as the VCs liquidation claim, i.e. the change in dividends or participation. 2.7 Monitoring and Value Adding Services As previously described, VC firms carefully time their investments step- by- step and make payments contingent on a variety of contractual provisions. VCs do however provide more than just money. In the course of the investment process, VCs continuously add value to their portfolio companies by screening, monitoring and decision- support functions (Jain and Kini (2000)). VC firms are usually specialized on a few industry sectors which is why they are able to offer superior assistance in financial and strategic planning as well as operational decision making (Barry (1994)). Although VCs try to mitigate agency problems and asymmetric information by fastidiously negotiated contracts, every possible conflict is impossible to cover. In other words, the founder s private benefits from certain projects may be imperfectly correlated with the shareholders interests. Hence, the VCs typically play a crucial role in the operations of their portfolio companies to check the project s status periodically and maintain the possibility to withdraw from the investment (Sahlman (1990) and Gompers (1995)). However, extensive monitoring is costly. According to Gompers (1995) monitoring costs also include the opportunity cost of generating returns for both the VCs and the entrepreneur. Writing and reading reports, setting up contracts as well as carefully evaluating the entrepreneur s activities can amount to substantial costs since the entrepreneur and the VCs have to spend a considerable amount of time and resources. In addition, monitoring stage- financing activities requires the negotiation of new contracts and the payment of lawyers that need to be added to the monitoring costs. Kaplan and Strömberg (2001) also refer to the expenses associated with the VCs monitoring activities and state that in approximately 20% of the investments in question, VCs are concerned about the amount of time spent on supervising the investment. Besides spending time on monitoring the portfolio company, VCs must

31 21 allocate time to meetings with bankers and accountants as well as screening new start- ups for future funding (Sahlman (1990)). VCs demand regular updates on a monthly basis of the portfolio company s operations and performance. They also tend to periodically review their investments by directly visiting them. Empirical findings state that in the course of the financing process, a lead VC visits the entrepreneur on average once a month for four to five hours, whereas non- lead VCs undertake a personal inspection only once a quarter for two to three hours. Although VCs usually hold board seats in the start- up, they try not to get too involved in the firm s day- to- day operations (Gorman and Sahlman (1989) cited in Gompers (1995)). Apart from reviewing and evaluating their investments continuously, VCs provide further services that contribute to an increase in the portfolio companies value and may enhance their performance. Dushnitsky and Lenox (2005) mention that especially young ventures lack complementary capabilities in marketing, distribution and manufacturing, i.e. the expertise and infrastructure to develop the product properly. An affiliation with a VC firm is beneficial to the entrepreneur for the following reasons: it enhances the venture s reputation and among other things leads to improvements in its R&D and distribution operations. Furthermore, VCs play an important role in attracting further investors such as banks and other VCs. They professionalize the start- up by developing its human capital, introduce the entrepreneur to their network of customers and suppliers and excel in establishing relationships between their portfolio company and the VCs closely tied investment bankers, auditors and lawyers which provide value enhancing services to the firm (Nahata (2008)).As already mentioned in sections 2.4 and 2.6, management risk is considered as one of the greatest uncertainties when investing into a start- up. For this reason, VCs take an active role in scrutinizing management actions, professionalizing the management and the set up of incentive compensation schemes (Chemmanur, Krishnan and Nandy (2011)). A VCs interventions in the composition of the portfolio company s management may even reach the point at which the VCs replace managers by own executives, e.g. in case the start- up is heading for disaster (Lerner (1995)). Kaplan and Strömberg (2001) find VCs playing a role in shaping the management team of their portfolio companies in 14% before providing capital and in 50% of the sample the VC firm explicitly expects to play after investing.

32 22 Various empirical literature address the above- mentioned services and monitoring activities that VCs provide to their portfolio companies and investigate its influence on several performance indicators. A study by Kortum and Lerner (1998) comes to the result that the presence of Venture Capital is responsible to approximately 15% of U.S. industrial innovations. Hellmann and Puri (2000) estimate a positive impact of Venture Capital participation in start- ups based on a significant reduction in the time to bring a product to the market. The impact of a VCs value adding services becomes even more distinct when evaluating a portfolio company s performance after the exit of the VCs, which is usually subsequent to the end of the lock- up period. Kraus and Burghof (2003) assume that portfolio companies get hard hit when VCs leave the investment resulting in an increase in the post- IPO underperformance. Consist with this prediction, Field and Hanka (2001) find a statistically significant three- day abnormal return of - 1.5% and a 40% increase in trading volume around the unlock day for their sample. They moreover point out that these effects are roughly three times larger for VC- backed firms than for non- VC- backed ones. 15 To overcome the underperformance problem, (Kraus and Burghof (2003) advice VCs to sell their equity stakes rather to institutions that exhibit similar specializations in monitoring than selling directly over the stock exchange. These findings suggest that the role VCs play in supervising the start- ups, shaping the management team and introducing the entrepreneurs to their network of professionals impinges upon the performance and development of the portfolio company which is supported by the following citation: It is far more important whose money you get than how much you get or how much you pay for it (Bygrave (1992) p.208 cited in Hsu (2004)) For similar results supportive to these findings please also refer to Brav and Gompers (1999). 16 Against this background, empirical literature often raise the question whether superior monitoring and value adding services lead indeed to the outperformance of VC- backed firms over non VC- backed ones or if its is owed to their abilities to select more promising and high- quality ventures so that the investment will in any case turn out as a success. Shu et al. (2010) conclude that although VCs have outstanding capabilities in identifying quality firms their long- run performance would not be guaranteed without the continuous involvement and monitoring services provided by the VC firm. This is consistent with results by Chemmanur, Krishnan, and Nandy (2011) who find evidence that both screening and monitoring positively contribute to improving firm efficiency.

33 The Initial Public Offering as an Exit Strategy It is usually common for start- up firms that they do not generate profits at all or at least enough to adequately compensate their investors in form of paying dividends or other means. Hence, the assessment of a potential exit strategy is of paramount importance of a VC firm to generate positive returns on its investment (see Giot and Schwienbacher (2007) and Schwienbacher (2008)). A huge scale of literature investigates the IPO as an exit of VC firms (see e.g. Meggison and Weiss (1991), Jain and Kini (1994), Gompers (1996), Brav and Gompers (1997) and Lee and Wahal (2004)). Cumming, Fleming, and Schwienbacher (2006) name the main five different exit strategies that VCs usually follow: (1) VCs take their portfolio company public in an IPO thus the shares are listed on a public stock exchange; (2) the portfolio company is acquired or merged in an acquisition or trade sale to a larger firm and the VCs as well as the entrepreneur sell their stakes to the acquirer; (3) in a secondary sale the VCs sell their portfolio company s stake to another firm or fund in contrast to the entrepreneur who keeps his stake; (4) in a buyback, the entrepreneur purchases the stake held by the VC firm thus gaining back total control over the firm; (5) a write off or liquidation in which the investors withdraw from the investment usually realizing little or zero profit. The two most common approaches for VCs to exit their investment is to take the portfolio company public by an IPO or sell it to another firm, i.e. trade sale (Schwienbacher (2008)). Schwienbacher (2005) studies the differences in European and U.S. Venture Capital exits and shows that IPOs are more frequently used in the U.S. to exit the investments (29.9% of the portfolio companies in question were transacted by an IPO until 2001 versus 25.3% for the European market). On the contrary, trade- sales and acquisition are not only the dominant way to exit investments in Europe but also show a higher fraction compared to trade- sales in the U.S. market (38.4% of trade- sales in Europe compared to 30.3% in the U.S.) In this section, the focus is set on the exit through an initial public offering. This is on the one hand due to the empirical analysis conducted in chapters 4 and 5 which

34 24 concentrates entirely on the IPOs of VC- backed portfolio companies and, on the other hand due to IPOs being typically the most profitable exit opportunity that offer the greatest benefits for the VCs, the entrepreneur and the limited partners in terms of reputation and compensation (Gompers and Lerner (2001)). However, the VCs and the investors usually do not sell their shares immediately after the portfolio company has gone public. Special agreements, also knows as lock- ups prohibits the insiders to sell their shares for a predefined period of time. These lock- ups are frequently employed to mitigate the adverse selection problem at the IPO date, hence firms faced with a greater adverse selection problems typically exhibit lengthy lock- up agreements (Brav and Gompers (1999)). An initial public offering can be considered as one of the most considerable events in a firm s history. Besides the satisfaction of immediate capital requirements, an IPO also provides the portfolio company with the opportunity for further subsequent public offerings of equity and other corporate securities. Apart from that, going public enables the firm to gain access to the capital market and also might positively impact its product market performance (Chemmanur, He, and Nandy (2009)). Although IPOs are the most profitable way to exit an investment, the total number of IPOs as well as the fraction of VC- backed ones experienced a tremendous decline in the U.S. after the dot- com bubble around the millennium (see figure 5). However, the share of VC- backed IPOs is relatively constant reaching a maximum of 63% and a minimum of 26% with one exception in 2005 were the share dropped to only 3%. Recent observations reveal that since 2011 every second IPO in the U.S. is affiliated with Venture Capital financing.

35 25 FIGURE 5: VENTURE CAPITAL- BACKED IPOS AS A FRACTION OF TOTAL U.S. IPOS FROM Several empirical investigations have estimated superior performance of VC- backed IPOs over non- VC- backed ones (see e.g. Brav and Gompers (1997) or Jain and Kini (1995)). In addition, the reputation of a VC firm also positively impacts the post- IPO performance of a portfolio companies as can be derived from various examples investigated by existing literature (Ivanov et al. (2008) or Nahata (2008)) 18 Ritter (2013) estimates the returns for VC- backed and non- VC- backed IPOs and finds considerable differences. The average first- day return for VC- backed IPOs between 1980 and 2010 is more than twice as high as for non- VC- backed ones (27.9% compared to 12.6%). With respect to the three- year buy- and- hold return, VC- backed IPOs also outperform firms not receiving VC financing. VC- backed IPOs reveal an average return over three years of 23.2% (market adjusted: %), whereas non- VC- backed firms only provide investors with 19.5% over a three- year time horizon. 2.9 Fund returns and Performance Persistence A large number of empirical literature investigates the performance of VC funds and their portfolio companies (see e.g. Guler (2007), Kaplan and Schoar (2005), Cochrane (2005)), but still little is known about capital flows, returns and their interrelation. This is mainly due to limited disclosure requirements for Venture Capital firms since this 17 The figure is based on IPO data gathered by Ritter (2013). 18 More information on the VCs reputational effect on post- IPO performance is provided in chapter 3.

36 26 asset class belongs to field of private equity investments (Kaplan and Schoar (2005)). The returns of VC investments might differ from returns of e.g. common stocks even if betas or other industry characteristics are held constant. Cochrane (2005) mentions several reasons for the performance differences. First of all, investments in a Venture Capital fund are a one- time commitment that are not tradable and cannot be reversed. 19 Due to the investment s great inflexibility and illiquidity, investors might require higher returns. Second, VC funds usually have a threshold value for the required initial investment which an investor has to exceed to participate in the fund. The initial investment often represents a sizeable fraction of an investor s wealth. This further amplifies the investor s expectation of high returns after the fund s termination. In the course of evaluating the performance of VC funds, empirical literature employs a huge set of performance indicators. Kaplan and Schoar (2005) and Harris, Jenkinson, and Kaplan (2013) estimate fund performance by comparing an investment in a VC fund to an investment in the S&P 500 index. To make results comparable, they calculate the public market equivalent (henceforth PME) on the basis of fund cash flows to indicate an out- or underperformance of the VC fund against the S&P Further performance measures are the internal rate of return (hereinafter IRR) which is most often applied in empirical research (see Kaplan and Schoar (2005), Guler (2007), Lerner, Schoar, and Wongsunwai (2007), Ljungqvist and Richardson (2003), Smith, Pedace, and Sathe (2010) and McKenzie and Janeway (2011)), the cumulative total value to paid- in capital (TVPI) and the distributed total value to paid- in capital (DPI) (see Kaplan and Schoar (2005) and Smith, Pedace, and Sathe (2010)). The results on VC fund performance are ambiguous among several different empirical investigations. A comprehensive paper by Kaplan and Schoar (2005) analyzes the performance of VC funds utilizing several performance measures. They find evidence that VC fund returns based on a capital weighted basis are on the one hand higher than the returns of the S&P 500 but on the other hand lower when applying an equal- weighted basis. 21 An estimated PME ratio of 0.96 for VC funds between 1980 and 2001 indicates a slightly worse performance than the market index on an equal- weighted 19 See also chapter A PME greater 1 indicates that the VC fund outperformed the market index and vice versa. 21 However, VC fund returns are always higher than the S&P 500 return when estimating the performance gross of fees.

37 27 basis but a distinctly superior performance when weighting the funds by size (PME of 1.21). A research paper conducted by Harris, Jenkinson, and Kaplan (2013) comes to the conclusion that VC funds have underperformed the market by about 5% since the millennium. The analysis of VC fund performance on the basis of the IRR clearly depicts that some empirical studies measure insanely high returns, others show a relative moderate or even poor performance. McKenzie and Janeway (2011) find that VC funds might exhibit high IRRs of up to 20% in times of capital shortage and boom periods but on the contrary, the IRR decreases to skinny 4% when market conditions are unfavorable. Smith, Pedace, and Sathe (2010) estimate IRRs for a matched sample of 1,285 U.S. VC funds and come to the result that IRRs are highly skewed. The simple average IRR is 13.7% and is supposed to be below the common perception of a VC fund s return. However, for the top 10% of the sample funds the IRR is 39.2% or even higher. This average IRR is more or less consistent to the average IRR estimated by Kaplan and Schoar (2005) which is 17% for a sample of 746 VC funds. It is noteworthy that again results are highly skewed, i.e. some funds perform poorly, other exhibit an extremely high performance. The results obtained by Josh Lerner, Schoar, and Wongsunwai (2007) are even more extreme. They find the worst fund returning - 94% and the best one realizing an IRR in excess of 500% with an average IRR of moderate 6.7%. Results by Cochrane (2005) and Ljungqvist and Richardson (2003) coincide with those previously mentioned. Cochrane (2005) estimates returns applying a market model in logs and reports a market beta of 1.7 and an arithmetic alpha of The returns also exhibit some high degree of volatility. Accordingly, Ljungqvist and Richardson (2003) investigate the performance of 19 VC funds and find an average weighted portfolio beta of 1.12 and general excess returns of private equity funds with a magnitude of 5-8% p.a. compared to the public equity market. Interestingly, the largest proportions of VC gains are realized after the IPO of the portfolio company. VC firms usually continue to hold their stakes in the portfolio company after it went public. On average, VCs hold about 34% of the firm s equity prior to the IPO and only sell approximately 6.6% at the IPO date (Barry et al. (1990) cited in Jain and Kini (1995) p. 595). However, the sentiment of empirical literature concerning the overall performance of VC funds seems quite pessimistic (see e.g. Lerner (2011)). Although VC funds exhibited

38 28 superior performance compared to other public equities in the 1990s, the opposite seems to be prevailing in the 2000s (Harris, Jenkinson, and Kaplan (2013)). Due to the recently poor performance, low returns are considered to be inappropriate given the high riskiness and uncertainty of this particular asset class (Achleitner, Engel, and Reiner (2013)). Figure 6 provides and overview about the exit of almost 12,000 VC investments and shows that almost every fifth investment fails and only 14% of all investments considered between 1991 and 2000 make it to an IPO. A potential reason for the high volatility of VC funds as well as the recently noticed poor performance is the overreaction of investors to potential investment opportunities. Hence, too much capital is invested in relatively unattractive investments leading to moderate returns (Achleitner, Engel, and Reiner (2013)). Consistent to that, Lerner (2002) refers to an overfunding of particular sectors that may negatively impact venture capital funds effectiveness. FIGURE 6: THE EXIT ROUTES OF VC- BACKED FIRMS BETWEEN 1991 AND 2000 Although market conditions play a crucial role in determining the performance of a VC fund several studies emphasizing on the VC funds performance persistence and its determinants name additional reasons. Achleitner, Engel, and Reiner (2013) and Smith, Pedace, and Sathe (2010) consider the VC s prior experience, reputation, abilities to syndicate and skills to select and monitor their investments as the foundation of superior investment performance. Moreover, Kaplan and Schoar (2005) find evidence that if a VC s fund outperformed the industry once, a follow- on fund set up by the same